Fin- ct 9

FINANCIAL MANAGEMENT (PART 4)

INTRODUCTION OF

CAPITAL BUDGETING PART- 1

1. INTRODUCTION

Dear students, welcome to the lecture series on capital budgeting. Today in this

lecture, we shall learn about meaning, nature and importance of capital

budgeting, what is the process involved in capital budgeting and the types of

capital budgeting decisions. The objective of this lecture is to understand the

conceptual frame work of capital budgeting, the meaning and significance of

capital budgeting, the mechanism of capital budgeting process from identification

of investment opportunities till its implementation and review and we shall also

learn various type of capital budgeting decisions.

2. TYPES OF EXPENDITURE

We will learn certain basic concepts before understanding the concept of capital

budgeting. What is investment? Investment is the expenditure in the expectation

of some benefit; hence expenditure can be of two types, revenue expenditures

and capital expenditures.

Revenue expenditures are those expenditures which are charged to profit and loss

account. They are incurred for the following reasons, first to trade of business that

is for running the business, such expenses are selling and distribution expenses,

administrative expenses and finance expenses.

Secondly, they are incurred for maintaining the earning capacity of fixed assets,

example, repairs of machinery, second type of expenditure is capital expenditure.

They are the expenditure which are incurred for acquisition of fixed assets and for

improving their earning capacity. They are not charged to profit and loss account

but they are shown as fixed assets in the balance sheet, example, plant and

machinery building.

3. MEANING OF CAPITAL BUDGET AND CAPITAL BUDGETING

What is capital budget? It’s a list of expenditure which we need to incur. Under

capital plans,

we allocate the expenditure towards the various fixed assets. What is the meaning

of capital budgeting? It is the process of planning the acquisition of long term

assets.

Let us learn the definition in detail what is capital budgeting. Capital budgeting

decisions are related to allocation of resources to different long term assets, it

denotes a decision situation where lump sum funds

are allocated to the long term assets from which arises the benefit over a period

of year, that is if I incur an expenditure today, I will earn the benefits in the

coming years, that is in near future, year 1,2,3, I will reaps benefits. Now the

capital budgeting decision involves entire process of decision making relating to

acquisition of an asset from which returns are received over longer period,

examples are to buy machinery, if I buy machinery today, I will reap its benefit in

a longer period because I will use it in production and my production will continue

year after year. Second to undertake a research and development program, third

example is diversification of a product line, it means if a company is into the

textile industry,

it can diversify its product line by going into retail business or to launch a

promotional campaign. These are the examples of capital budgeting projects.

4. IMPORTANCE OF CAPITAL BUDGETING

What is the importance of capital budgeting? There are basically five factors which

are important in any capital budgeting decision, they are cost, time, risk,

irreversible decisions and complexities.

What is cost? Cost means the initial cost of a project, we need to incur initial cost

on project, initial cost here means cost of acquisition of some asset and if its

expansion project,

we may need some additional working capital, so that cost shall be added to the

cost of asset or project and if it’s a case of replacement, cost of replacement of

asset shall be the cost of the project and if I am able to receive certain salvage

value, by selling that asset, that cost shall be reduced by that amount of salvage.

We will learn about second thing, that is time element, the effect of decision is

known only in the near future and not immediately because my cash out flows are

in the current period while my returns are coming in near future that is

subsequent years its coming, it’s an irreversible decision, why it’s an irreversible

decision because once I have employed my funds into the acquisition of a fixed

asset, I cannot revert back. The funds will be block into that asset for a longer

period of time, even if I want to come out of that project, I won’t be able to come

out without losses, example if I invest my money in plant and machinery and if I

am going to market for selling it immediately, I won’t be able to fetch a same

amount of money as I have purchased, so differential amount shall be a loss and

that can be substantial. Next comes complexity, decision based are on forecasting,

forecasting of future events and in flows. How shall I quantify my inflows, they

shall be quantified on the basis of certain statistical and probabilistic techniques,

hence I need to be very careful while applying my mind to trace out the inflows

and projected outflows. Fifth comes risk, the longer the period, the greater the

risk, uncertainties associated with cash flows are higher as the period is higher,

hence decision should be taken after a careful review of all the available

information, with this we have concluded importance and meaning of capital

budgeting.

5. FACTORS AFFECTING CAPITAL BUDGETING DECISIONS

We shall learn about the factors affecting capital budgeting decisions. First is net

investment outlet,

it means again the initial cost that is what cost I need to incur. It shall be the sum

of cost of new asset purchased plus investment in working capital, less salvage

value of old asset if any,

For example,

our cost of new machinery is 90,000 and I need additional working capital of

10,000, so we will reach the cost initial cost as 1,00,000 rupees. If it is a

replacement decision,

our cost of replacing the asset shall be initial cost, for example it is 65,000 rupees

and we can get salvage value of 5,000 rupees by selling that old asset.

So salvage value shall be deducted from cost of replacing the old asset, the cost

comes out to be rupees 60,000 and it will amount to net investment outlay for the

project. Second factor is net cash inflow or benefit, it means cash flow after tax

and we need to add back depreciation and other amortization.

Why we need to add up depreciations because depreciation is a non cash item, we

do not need to spend money on such item of financial expenses. It is a totally non

cash expenses, how shall we compute cash flows after tax? We will take up the

figure of earnings before interest and tax;

reduce the financial charge, that is interest, what we are getting is earning before

tax, now reduce it from the taxes, what is left out is earnings after tax, they are

called cash flows after tax. We shall add up depreciation again in this figure so

arrived, so we will get cash flows, this way, we shall compute our net cash

inflows. Third factor is project life;

project life means the time period during which a project can give us positive

cash flows after tax, it is different from physical life of an asset. It is more an

economic life rather than physical life provided by the supplier. For example, if an

asset is able to generate cash flows after tax for 5 years of its life, the project life

shall be 5 years. Next comes is desirable minimum rate of return, it is also called

as cut off rate or average cost of capital. A project should earn at least returns

equal to cost of capital, so it’s a selection criterion for accepting or rejecting a

project. If my return from projects comes, greater than cost of capital, we shall

accept that project. So this is the rate which we need to earn from a project, it

shall be computed as weighted average cost of capital, there are prescribed

formula’s for computing weighted average cost of capital. Moreover it covers the

risk associated with the project as it takes into account interest element. Last

comes opportunity cost, opportunity cost means cost of forgoing one alternative to

accept the other. With this, we have completed the factors affecting capital

budgeting decisions.

6. CAPITAL BUDGETING PROCESS

Students, now we will learn about capital budgeting process. Process as the names

suggest, it involves lot many steps so we will learn this step by step.

First comes identification of investment opportunity, second assembling of the

proposed investment, third shall be screening of the project, fourth economic

evaluation of the proposal, fifth decision making, sixth preparation of capital

budget, seventh authorization of capital expenditure, eight its implementation and

ninth and final is performance review. What is identification of potential

investment opportunity? The first step in capital budgeting process is identifying of

investment proposal, such identification can be started at any level of

management.

For example,

suggestions for improvement in the production process can be given by a foreman.

So the generation of investment proposal can be made either by the grass root

level of people or up to top management. Second comes, assembling of the

proposal, when the origin of investment proposal has taken place, then

presentation of the proposal shall take place, the proposal needs to be presented

in a prescribed format. It shall include date of project, project identification

number, purpose of the project, estimated total cost of the project, estimated

start and end time of the project, estimated period by which earnings shall be

started in the project and estimated cost savings and reduction in cost. This way,

a proposal shall be presented to the planning committee.

Once the proposal is presented in the prescribed format, the screening of that

proposal shall be done by budget committee or planning committee. They shall

find out whether this proposal is as per the standard set by the committee or top

management.

They shall look into the project to find out whether it is line with the long term

development program of the company or not. If they found suitable, then further

economic evaluation of these proposal shall be done else it shall be rejected. Now

the budget committee or planning committee shall do the economic evaluation of

the proposals that has been screened. Under economic evaluation, they shall find

out cost benefit analysis

that is they will trade off between the cost and benefits occurring from that

project. Cost shall be the initial cost and benefits will be the cash flows which we

are generating over the years, this trade off can be done using capital budgeting

techniques which we will learn later on. These techniques can be net present

value techniques, payback period techniques, accounting rate of return techniques

and so on. After it has been evaluated economically, next step is decision making.

If the project is profitable, that is the benefits exceeds cost, we will accept that

proposal and send it to the board of directors with the recommendation. If board

of directors find it appropriate as per all the standards and norms, they will

allocate their funds to the finance manager for planning the capital budgets.

Hence capital budgets are plan of expenditure which needs to be undertaken for

various capital budgeting proposals. Once capital budgets are chalked out, then

authorization of expenditure shall be given to the respective heads. After getting

authorization for capital expenditure, the project shall be executed and

expenditure will be incurred on that very project. Once a project is executed, we

shall find out if any deviation is there between the standards so set and actual

expenditure incurred, so now from stage of execution,

we are coming to the stage of control, we will find out deviations. Reasons of

deviations, for this, there shall be certain reports generated

which are called capital expenditure report, inspection reports, audit reports, we

shall be furnish to top management so that these deviations either can be traced

out, two possibilities are there, either we will revise the cost budgets or we shall

control the cost, hence we have completed this capital budgeting process.

7. TYPES OF CAPITAL BUDGETING DECISIONS

Students, having understood the process of capital budgeting, we shall learn about

types of capital budgeting decisions. Capital budgeting decisions can be based on

firm’s existence or on nature of decision.

What are the capital budgeting decisions which are based on firm’s existence?

They can be either for cost reduction or for revenue expansion. Cost reduction

decisions shall focused on reduction of operating cost and improving efficiency

while revenue expansion decisions will focus on increasing sale, new products,

product version etc. under cost reduction decisions, two types of decisions are

there, replacement decisions or modernization decision. Under revenue expansion

decisions, again two sorts of decisions are there, first expansion, another is

diversification decision. What is replacement decision?

Replacement decision means to replace the existing asset with a new and

improved one, example; version of the equipment has changed.

It mostly happens in the case of technology, computers. Second is modernization,

install new machinery in the place of old one which has become technological

outdated, for example, in a Handloom, earlier, certain manual machine was used,

now that will be replace by totally new machine with advanced technologies.

This is called modernization.

Now we will learn about revenue expansion decisions. First one is expansion,

expansion means to add capacity to existing product line, to meet increase

demands, to improve production facilities and to increase market share of existing

products. Second is diversification, diversification means to going into new

business or to a new product line, for example,

X company was dealing in a textile industry, now it wants to put its hand into the

retail industry, so that is called diversification. Earlier a company was producing

garments, now it wants to produce Pharmaceuticals, so this way product has been

expanded or industry such has been expanded, this is called diversification. Now

there are certain decisions which are based on nature of decisions and they are

very crucial while solving the problems of capital budgeting.

They are mutually exclusive decisions; accept reject decisions or capital rationing.

What is a mutually exclusive decision? Acceptance of one alternative will result in

rejection of another alternative, for example, if I accept machine A, the rejection

of machine B is automatically done,

accept reject decisions are those decisions where projects are independent, that

means they do not compete with each other for the selection criteria. If they are

profitable, they will be accepted, if they are not profitable, they won’t be

accepted. Provided company has funds available for accepting those projects. Now

comes capital rationing, capital rationing decisions are those decisions where

funds are not adequate while proposals are too many, means proposal A can also

be accepted, B can also be accepted and C can also be accepted but I don’t have

so much of fund that I can cover all the three proposals, so I will do the rationing,

the most profitable project will be given preference afterwards less profitable and

then the least profitable. This way, we have concluded the type of capital

budgeting decisions.